It has been a nerve-wracking several years for investors, but economic data and market indicators are pointing to a real and hopefully permanent change in the tone of the market. As I explain in the attached video, two things investors can watch for confirmation of the end of the "risk-on / risk-off" environment are:
1. Declining correlations among stocks and major asset classes. The realized correlation within equities has dropped significantly, back to pre-crisis levels, and that's a very good thing. But the correlations among oil, the euro and other assets to equities is still quite high, and that net absolute correlation should keep dropping as investors focus more on the fundamentals.
2. The return to form of the carry trade. ETFs like iPath Optimized Currency Carry ETN(ICI) and Powershares DB G10 Currency Harvest Fund(DBV) track strategies that profit from the carry trade in G10 currencies. In recent years, those strategies haven't worked nearly as well as their historical records would suggest, partly because investors have been prone to rush back and forth between perceived safety and risk, paying less attention to the fundamentals of particular currency pairs. As world economies start distinguishing themselves again and investors think less about tail risk and more about return potential, carry relationships should normalize.
It almost goes without saying, but the prospects for normalizing markets and declining tail risk all still depend on the how much austerity the U.S. inflicts upon itself in the coming weeks. Unfortunately, both the President and Congress apparently believe that pro-cyclical, anti-growth policies are called for at this moment despite all of the evidence in economic history indicating that the time to raise taxes and/or cut spending is during an economic boom, not during a tenuous recovery. Still, assuming that the self-harm is not too serious, the prospects for healthier markets next year are looking up.
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